A bubble we can use: mortgage refinancing

Since the financial crisis, banks have struggled to fill the multi-billion-dollar hole that mortgage securitization caused in their income statements. Announcing their quarterly earnings this morning, JP Morgan and Wells Fargo seem to have found at least a partial replacement: mortgage refinancing.

JP Morgan’s third quarter produced a record $5.7 billion in profit. Importantly, that result also reversed a four-quarters-long trend of declining year-over-year financial performance. Their mortgage business originated $47 billion in loans and produced a record $2.4 billion in revenue (full financial details here). But this wasn’t a sudden blow-out: JP Morgan has had over $2 billion in mortgage related revenue for each of the first three quarters of 2012, a 234% increase over the same period in 2011.

Wells Fargo also came in with a strong $4.9 billion in profit, up 22% from last year’s third quarter. They originated $139 billion in mortgages and $131 billion in the second quarter. Mortgage revenue and income were down substantially, but only, it seems, because of a decision to keep more mortgages on balance sheet, thus missing out on an estimated $200 million in revenues from selling mortgages it originated. But the value is still there.

There’s no question that refinancings are dominating this new found strength in the mortgage business. At Wells Fargo, refinancings were 72% of mortgage applications in the third quarter. And they’ve been high for the last year: 69% in Q2; 76% in Q1; 78% in Q4 2011. These numbers are right in range with the industry as a whole: Dealbook’s Peter Eavis says that based on data from Inside Mortgage Finance, 68% of all mortgages originated in the second quarter were refis. To put those percentages into perspective, Bill McBride at Calculated Risk shows that refis are at their highest level since 2009. What’s behind the surge in refinancings relative to loans to buy new homes?

One obvious response, low rates, doesn’t actually provide a full answer. The has Fed, via QE1-3, succeeded in making it profitable to lend, all the while keeping interest rates low. But profitable, low-rate lending works just as well for home-purchase mortgages as it does for refis. Low rates help explain an increase in mortgage lending, but not why mortgage lending is currently skewed towards refinancing.

Another seemingly obvious explanation, that the federal program designed to help underwater homeowners refi is actually working, gets you closer to an explanation but still falls short. The “Home Affordable Refinance Program” has indeed been more effective since its overhaul. But this only helps to helps explain why the absolute number of refinancings might increase. Like QE, it’s part of the answer but still doesn’t make sense of the lack of new home loans relative to refis.

The get the full answer, you have to recognize that consumer de-leveraging, un(der)-employment, and wage stagnation has left fewer and fewer Americans with the money for a down payment. Refinancing has costs, but they are microscopic compared to 20% of the value of a new home. What’s more, they produce immediate month-to-month cash savings. And borrowing from banks may still be a hassle, but things are marginally easier when the bank already has data on the borrower and the asset.

Together, QE, federal assistance, consumer debt and income trends, and institutional inertia explain the refi boom. And it still has a long way to go. No only would more than half of all US homeowners save from refinancing (via Eavis’ article above), but this quarter’s impressive numbers from JP Morgan and Wells Fargo (closed September 30) barely take into account the very real impact of QE3 (announced September 13). QE3 will push banks to hand out more mortgages, and when they do, it will be largely in the form of refis for quite a while.

That won’t have quite the impact that a huge spike in new home sales would, but it will give Americans a little more money to spend each month and it will also give banks a profit motive in allowing homeowners to free up cash. There are other ways to boost the economy more quickly, directly, and broadly, but QE3 has partially solved the vexing question of how to get banks to help finance some portion of an American economic recovery.